We can divide the 20th century into 88 twenty-year periods. Though most periods generated positive returns before dividends and transaction costs, half produced compounded returns of less than 4%. Less than 10% generated gains of more than 10%. The table below reflects that higher returns are associated with periods during which the P/E ratio increased, and lower or negative returns resulted from periods when the P/E declined.
There were only nine periods from 1900-2002 when 20-year returns were above 9.6%, and this chart shows all nine. What you will notice is that eight out of the nine times were associated with the stock market bubble of the late 1990s, and during all eight periods there was a doubling, tripling, or even quadrupling of P/E ratios. Prior to the bubble, there was no 20-year period which delivered 10% annual returns. Every period of above-9.6% market returns started with low P/E ratios. EVERY ONE.
Look at the following table from my friend Ed Easterling's web site at www.crestmontresearch.com (which is a wealth of statistical data like this!). You can find many 20-year periods where returns were less than 2-3%.
The higher the P/E ratio, the lower (in general) the subsequent 20-year average return. Where are we today? As I have made clear in my last two letters, we are well above 20. Today we are over 30, on our way to 45. In a nod to bulls, I agree you should look back over a number of years to average earnings and take out the highs and lows of a cycle. However, even "normalizing" earnings to an average over multiple years, we are still well above the long-term P/E average.
In terms of valuations, markets cycle up and down over long periods of time. These are called secular cycles. You have bull and bear secular cycles. In a period of a secular bull, the best style of investing is relative value. You are trying to beat the market. These periods start with low valuations, and you can ride the ups and downs with little real worry. Think of 1982 though 1999.
But in secular bear cycles, the best style of investing is absolute returns. Your benchmark is zero. You want positive numbers. It is much harder, and the longer-term returns are probably not going to be as good. But you are growing your capital against the day the secular bull returns. And, as bleak as it looks right now, I can assure you that bull will be back. Some time in the middle of the next decade, maybe a little sooner, we will see the launch of a new secular bull.
[I'm not sure, but I don't believe the above data takes into account dividends. If so, then I'd have to say the study is seriously misleading. -mc]